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Are liabilities always a bad thing?

Author:
Harold Averkamp, CPA, MBA

Definition of Liabilities

Liabilities are a company’s obligations and are usually defined as a claim on the company’s assets. However, liabilities (and stockholders’ equity) can also be viewed as the sources of the company’s assets.

The money raised by a company’s liabilities will generally have a lower cost than money raised from stockholders’ equity for the following reasons:

  • Some liabilities such as accounts payable have no interest expense associated with them
  • The interest on loans is deductible on U.S income tax returns, thereby reducing the net cost of the borrowed money

Therefore, liabilities that allow a company to acquire more assets to improve efficiency, safety, etc. without reducing the existing owners’ share of the business is actually a good thing..

On the other hand, liabilities will be a bad thing when they are so large that the company cannot weather a business downturn.

Example of Liabilities

Assume a corporation needs to replace its existing equipment with equipment that has the latest new technologies. The new equipment will result in better products at a lower cost. If the corporation is able to borrow the money needed at say 7% interest, the interest expense after the income tax benefit may be only 5%. If the cost savings from the new equipment does occur, the corporation’s present owners will enjoy the increased earnings without a reduction in their ownership percentages.

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About the Author

Harold Averkamp

For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

Learn More About Harold

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